Osborne Keeps Austerity as Investors Discount Downgrade

U.K. Chancellor of the Exchequer
George Osborne won’t bow to opposition calls to change economic
plans after the decision by Moody’s Investors Service to strip
the U.K. of its Aaa status.

Osborne said in an article for the Sun newspaper yesterday
that the government should “stick to its course” to reduce
Britain’s debt. The opposition Labour Party called on him to
switch his emphasis from deficit reduction to growth, following
what it called Moody’s “humiliating” decision. Labour Treasury
spokesman Ed Balls will question the chancellor on the downgrade
in Parliament in London today.

The downgrade of the U.K. to Aa1 sparked a round of
political sparring after Osborne repeatedly referred to
retaining the top rating as a test for his economic policy. At
the same time, investors and economists said rating cuts are a
poor indicator of fiscal health. U.S. and French yields are
lower than they were when rating companies downgraded the
nations over the past two years.

“The rating change tells us only what we already knew,”
said Rob Wood, an economist at Berenberg Bank in London. Still,
“the change could put a little more pressure on sterling, a lot
more pressure on Osborne, and may dent near-term growth a
little.”

The pound today weakened against all but the yen among 16
major currencies tracked by Bloomberg. It fell 0.3 percent to
$1.5115 as of 1:35 p.m. London time after earlier dropping to
$1.5073, the weakest since July 2010. It declined 1.1 percent
versus the euro.

The yield on the 10-year gilt rose 3 basis points to 2.14
percent. That compares with a record low of 1.407 percent on
July 23 and an average of 3.945 percent in the past decade.

Osborne Testimony

Mark Allan, an economist at Axa Investment Managers in
London, said the rating cut by Moody’s was “no surprise.”

Still, while the uncertainty over the timing of the
downgrade “has been reduced by this decision, it is only the
start of the political pressure,” he said.

Labour said it expects Balls to question Osborne on Moody’s
in the House of Commons at about 3.30 p.m. The chancellor is
then due to give evidence to U.K. lawmakers at the Parliamentary
Commission on Banking Standards at about 4:30 p.m. in London.

Osborne said yesterday that the downgrade was a “stark
reminder” of the “single most important truth about our
economy; Britain has a debt problem, built up over many years,
and we have got to deal with it.”

Weak Economy

Moody’s blamed the downgrade on the “continuing weakness”
of the U.K. economic outlook and the challenge this poses to
Osborne’s fiscal plans. While the U.K. retains “considerable
structural economic strengths,” Moody’s also said its rising
debt burden reduces its “shock-absorption capacity.”

The economic recovery is also troubling the Bank of
England, where Governor Mervyn King and two other policy makers
voted to increase stimulus this month. While they were defeated
at the Feb. 6-7 meeting, officials discussed a range of measures
to help the economy, including steps to boost credit.

The British Bankers Association said today that mortgage
approvals fell to a four-month low of 32,288 in January from
33,440 in December. Approvals dropped 14 percent from a year
earlier, partly due to cold weather.

“January’s severe weather impacted adversely on what was
already a subdued picture,” said David Dooks, BBA director of
statistics. “While general economic growth stalls, low consumer
and business confidence generates a natural tendency to restrain
borrowing appetite.”

Downside Risk

“The risks to the growth outlook remain skewed to the
downside,” Moody’s said. “Despite considerable structural
economic strengths, the U.K.’s economic growth will remain
sluggish over the next few years.”

Moody’s said part of the U.K.’s poor outlook is due to the
“anticipated slow growth of the global economy.”

China’s manufacturing expanded at the slowest pace in four
months in February, a survey today showed. A preliminary index
fell to 50.4 from 52.3 in January, below the 52.2 median
estimate of 11 analysts in a Bloomberg News. A number above 50
indicates expansion.

Market Impact

“We don’t expect much market impact from the downgrade --
it was widely expected,” said David Tinsley, an economist at
BNP Paribas SA in London. “But this all comes at a time of poor
news flow and highlights the U.K.’s vulnerabilities.”

Yields on sovereign securities moved in the opposite
direction from what ratings suggested in 53 percent of 32
upgrades, downgrades and changes in credit outlook last year,
according to data compiled by Bloomberg published in December.
That’s worse than the longer-term average of 47 percent, based
on more than 300 changes since 1974. Investors ignored 56
percent of Moody’s rating and outlook changes and 50 percent of
those by S&P.

Britain’s debt as a percentage of gross domestic product
will climb to 98 percent next year from 90 percent last year and
95.4 percent in 2013, the European Commission said in its winter
forecast on Feb. 22. Tinsley said other ratings companies may
also downgrade the U.K.

Osborne said in his autumn statement Dec. 5 that he’s no
longer likely to meet his target to begin cutting the burden of
government debt in 2015-16. Standard & Poor’s put the U.K.’s
rating on a negative outlook a week later.

Fitch Ratings, which lowered its U.K. outlook in March
2012, said on Dec. 5 that missing the debt target weakens the
U.K.’s credibility. It will review the rating in 2013
incorporating the budget, due March 20.

Fiscal Squeeze

Ed Balls, Labour’s economy spokesman, said Osborne should
scale back his fiscal squeeze and refocus on growth in his
budget on March 20.

“In the budget, the government must urgently take action
to kick-start our flat-lining economy and realize that we need
growth to get the deficit down,” Balls said.

Shahid Ikram, head of sovereigns and chief investment
officer for the U.K. at Aviva Investors, said asset purchases by
the Bank of England, where Bank of Canada Governor Mark Carney
will start work in July, will have a greater impact on gilts
than the downgrade.

“If the central bank decides to stop buying, gilt yields
will have to rise further,” Ikram said. “But again, there will
be investors out there, such as sovereign wealth funds, who
would bid for gilts when yields are higher.”

In terms of gilts, “the dominant factor remains the
prospect for more QE, which we think is likely,” Michael Amey,
portfolio manager at Pacific Investment Management Co., said in
an e-mail.